Options explained part 1; what are options? And how do options work?

Options explained part 1; what are options? And how do options work?

Many investors still have the idea that options are “dangerous” and risky. I totally disagree with this statement because option strategies are often used to limit risks. In order to successfully trade in options, some basic knowledge about the product is essential. What exactly are options? In my next two articles I help novice option traders to introduce them to this complex product. In the first article I explain what options are and I will define the most important concepts. In my second article I will elaborate on that in more detail.

Topics covered in this article:

Concepts

Call options and put options

Long & short

What are options and what types of options are there? Some concepts:

Call Option: Gives the right to purchase at a predetermined price.

Put option: Gives the right to sell at a predetermined price.

Underlying value: Product (stock or index) on which the option is based.

Expiration date: The expiration date of the option.

Exercise price (strike price): Predetermined price at which the buyer of an option can buy / sell the shares.

Writing an option: Selling an option.

Trading call options and put options

When trading options there are two types available, the call option and the put option. A purchased call option gives the right to buy the option shares at a predetermined price (the strike price) up to the expiration date. For this right, the investor pays an option premium. The call option seller receives the premium and has the obligation to exercise the option at the strike price. Selling an option is called “writing an option.”

For the right of a put option, the opposite applies. A purchased put option gives the right to sell shares at the strike price until the expiry date. When writing an option you can be obligated by the buyer of the option to buy the shares for the strike price.

Buy

Write

Call

Right to buy shares

Obligation to sell shares

Put

Right to sell shares

Obligation to buy shares

An investor who has a call option, only exercises his right to buy shares if the price of the underlying value is above the strike price at the expiry date (in-the-money). When the current price is below the strike price, the buyer of the call option is better off buying the shares directly at the stock market for the lower price. Note: the buyer has the right to exercise the options, not the obligation. The seller does have the obligation to sell the shares once the buyer exercises his right.

The same goes for put options, although now the investor only exercises his options when the price is below the current strike price. Indeed, he can sell his shares for a higher price with his options that he could at the stock market. The seller of the put option has the obligation to buy the shares if the buyer exercises his right.

Call options

Action buyer

Obligation buyer

Price higher than strike price

Buyer exercises call option

Seller has obligation to buy shares for the strike price

Price lower than strike price

Buyer does not exercises call option

None

Put options

Action buyer

Obligation buyer

Price lower than strike price

Buyer exercises put option

Seller has obligation to buy shares at strike price

Price higher than strike price

Buyer does not exercises put option

None

Every month new options are issues on the stock markets. For liquid shares it is standard to find options with maturities of 1, 2, 3, 6, and 12 months. Additionally, you will find shorter options on stock indices, like the Dax, FTSE 100, Dow Jones, Nikkei.

Besides the monthly issued options, there are also options issued with a maturity of one day. Options with a maturity of 5 years or less are considered liquid. Options are particularly popular in Holland. Dutch investors are considered as very active options traders at a European level.

Options notations

Below you see an example of how an option is quoted. By separating all parts of this notation I hope to make clear what everyting means.

XYZ CALL 18 DECEMBER 2015 € 50

XYZ: underlying value of the option.

CALL: This is the type of option. There are two types available, the call and the put option.

18 december 2015: this is the expiration date of the option.

€ 50: this is the strike price of the option. At this price the shares are purchased by the buyer of a call option, when he exercises his right.

Trading long & short options

When trading shares, options and futures, the concepts “long” and “short” are very common. In trading terms a long position means that a trader possesses the underlying value and anticipates on an increase of the underlying value. When you go short in shares, for example, a trader sells shares he does not possess, with the aim of buying them back later at a lower price. The difference between the selling price and the eventual purchase price of the share is profit for the trader. With a long position you make money when the share price rises; with a short position you make money when the share price falls.

Within the option world, the terms long and short get an extra dimension. When a trader has long call options in his portfolio, this means he has bought these call options. The same goes for put options, even though with put options you speculate on a decrease in value of the underlying value. For short call and put options (“written options”) the opposite applies. In the table below this is clearly defined.

Type

Action

Term

Anticipates on a

CALL

Bought

Long Call

Increase

CALL

Sold

Short Call

Decrease

PUT

Bought

Long Put

Decrease

PUT

Sold

Short Put

Increase

In my second article I will elaborate a bit more on the option itself. Among others, I will discuss the concepts of American and European style, Exercise and Assignment, in-the-money, at-the-money, out-of-the-money. Read the article: “Options explained part 2, settling options.